Invalidating an IRS Notice: Lessons and What’s to Come from Feigh v. C.I.R.

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A few weeks ago, the United States Tax Court decided Feigh v. Commissioner, 152 T.C. No. 15 (2019): a precedential opinion on a novel issue involving the Earned Income Tax Credit (EITC) and its interplay with an IRS Notice (Notice 2014-7). The petitioners in the case just so happened to be represented by my clinic, and the case just so happened to be a A Law Student’s Dream: fully stipulated (no pesky issues of fact), and essentially a single (and novel) legal issue. Because the opinion will affect a large number of taxpayers, I commend those working in low-income tax to read it. What I hope to do in this blog post is give a little inside-baseball on the case and, in keeping with the theme of this blog, tie it in a bit with procedural issues.

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Posture of the Case

I frequently sing the praises of Tax Court judges in working with pro se taxpayers. This case provides yet another example. My clinic received a call from the petitioners less than a week before calendar. Apparently, the Tax Court (specifically Judge Goeke) had recognized that this was a novel issue of law and suggested to the low-income, pro se petitioners that they may benefit from contacting a Low-Income Taxpayer Clinic for help with the briefing.

By the time the client contacted me (again, only a few days before calendar) the IRS had moved for the case to be submitted fully stipulated under Rule 122. The Court had not yet ruled on the motion but I mostly found the stipulations unobjectionable (with one minor change, which the IRS graciously did not object to). Rather, what concerned me was the fact that it was designated as an “S-Case.” I wanted this case to be precedential, and I wanted to be able to appeal –neither of which are possible for S-Cases. See IRC § 7463(b). Yes, the Court can remove the designation in its own discretion (see post here), but I didn’t want to leave anything to chance. After consulting with my clients the first order of business was to move to have the S designation removed -which again saw no objection from the IRS. Now the table was set for briefing on the novel issue.

What’s At Issue?

I’m going to try hard not to dwell on the substantive legal issues in this case, important though they are. Nevertheless, an ever-so-brief primer on what was going on is necessary.

Our client (husband and wife) received Medicaid Waiver Payments for the services the wife provided to her disabled (non-foster) child. From conversations with local VITA organizations I already anecdotally knew that some people received these payments, but since taking this case on I have come to appreciate exactly how vast the Medicaid Waiver program is. For our client, the Medicaid Waiver Payments were made in the form of rather meager wages (a little over $7,000) that were subject (rightly or wrongly) to FICA. They were the only wages my clients had. When my clients went to file their income tax return, however, it looked like they were getting a fairly raw deal: namely, missing out on an EITC and Child Tax Credits cumulatively worth almost $4,000. Why? Because in 2014 the IRS decided that these Medicaid Waiver Payments were excluded from income as IRC § 131 “Foster Care” payments.

An exclusion from income sounds to most taxpayers like a good thing: it’s always better to have less taxable income, right? But the tax code is a complicated animal, and for lower-income taxpayers the exclusion of wages was actually a curse: to be considered “earned income” for both the EITC and Child Tax Credit (CTC), wages must be “includible” in income. By the IRS’s logic, this meant that you must exclude your $7,000 Medicaid Waiver Payment (with a tax benefit of $0 in some cases) and couldn’t thereafter “double-benefit” by also getting the EITC/CTC for those excluded wages.

It doesn’t quite seem fair for those who saw little or no tax benefit from the exclusion.

It seems even less fair when you consider that those who would actually phase out of the EITC (say, by receiving a large Medicaid Waiver Payment over $52,000, which has happened) not only would get a larger tax benefit from the exclusion, but could still potentially get the EITC if they had other wages (say, from the other spouse). Theoretically, a couple making $100,000 could get the EITC in this case if the greater portion of the income were Medicaid Waiver Payments. This would be the case because such payments would be disregarded for EITC eligibility calculation altogether. Probably not what Congress (or even the IRS) had in mind.

My clients felt like they should do something about this unfairness. So they did: they took both the exclusion of IRS Notice 2014-7 and the EITC based on the excluded wages. This of course led to a notice of deficiency and culminated in the precedential Feigh decision.

Our Legal Arguments

Because of our client’s novel stance, we had two points we had to make for our client to win: (1) that the wages could be included in income, and (2) basically, that was it. We wanted to make it a simple statutory argument: If the wages could be included, then they were “includible,” and that was all that was required of the EITC under IRC § 32(c)(2)(A)(i).

As to the first point -whether the payments could (maybe, should) be “included” in income- history was on our side. Prior to 2014 courts and the IRS agreed that such payments had to be included in income. Payments for adopted or biological children clearly did not meet the statutory language of excluded “Foster Care Payments” under IRC § 131. The only thing that changed in the intervening years was the IRS issuance of Notice 2014-7: there was no “statutory, regulatory, or judicial authority” that could anchor the change in treatment. As we argued, the IRS essentially transformed “earned income” into “unearned income” on its own. And that sort of change is a massive bridge too far through subregulatory guidance.

We won on that first issue handily. The Court noted that “IRS notices –as mere statements of the Commissioner’s position—lack the force of law.” Then, the Court applied Skidmore deference (see Skidmore v. Swift & Co., 323 U.S. 134 (1944)) to see whether the interpretation set forth by IRS Notice 2014-7 was persuasive.

It was not.

And the IRS could not, through the notice, “remove a statutory benefit provided by Congress” -like, say, eligibility for the EITC. That sort of thing has to be done through statute. For administrative law-hawks, the Tax Court reigning in the IRS’s attempts to rule-make without going through the proper procedures is probably the bigger win. (As an aside, I’m not entirely positive even a full notice-and-comment regulation could do what Notice 2014-7 tries to: I don’t think any amount of deference would allow a reading of IRC § 131 the way Notice 2014-7 does.)

So we cleared the first hurdle: the IRS can’t magically decree that what was once earned income is no more through the issuance of subregulatory guidance. But what of the second hurdle -the fact that our client undeniably did not include the wages in gross income?

Courts have (rightly) treated the terms “allowable” and “allowed” differently, as well as “excludible” vs. “excluded” in previous cases. The breakdown is that the suffix “able” means “capable of” whereas the suffix “ed” means “actually occurred.” See Lenz v. C.I.R., 101 T.C. 260 (1993). Coming into this case I was keenly aware of this distinction because of a law review article I read while writing a chapter on the EITC for Effectively Representing Your Client Before the IRS. Indeed, it was that aspect of the EITC statutory language (and not my familiarity with Notice 2014-7 or Medicaid Waiver Payments) which made me want to take this case from the beginning. I feel compelled to raise the value of that law review article (James Maule, “No Thanks, Uncle Sam, You Can Keep Your Tax Break,”) because so many law professors joke that no one reads law review articles, or that most articles are impractical (no comment on the latter).

Consistently with the distinction of “allowed” vs. “allowable,” the Court has previously ruled on the nuance of “included” vs. “includible.” See Venture Funding, Ltd. v. C.I.R., 110 T.C. No. 19 (1998). “Included” means it was reported as income, “includible” means that it could/should be reported in income. Since the Tax Court already found that we met the first hurdle (our client could include the payments in income and Notice 2014-7 can’t take that away), we were in the clear: it was “includible.”

And so our client has excluded income and the earned income credit derived from it… Impermissible double-benefit, you (and the IRS brief) say?

I disagree. Not only does treating excluded payments as earned income apply the statutory language correctly, and more in line with what Congress would want, I contend that it is the better way to protect the integrity of the EITC. To see why this is you have to look again at how the EITC is calculated, and how the phase-out applies. In so doing we see that the real problem would be in disregarding excluded income altogether.

The Integrity of the EITC

The EITC is means tested, but it calculates the taxpayers means through two separate numbers: (1) “earned income” and (2) “adjusted gross income (AGI).” See IRC § 32(a)(2) and (f).  Excluded income isn’t reflected in AGI, so people with high amounts of excluded income might escape the AGI means testing prong of the EITC -unless the excluded income is specifically caught through other IRC 32 provisions like limits on investment income or foreign income exclusions. (Note that excluded alimony payments post TCJA would not be incorporated in the means testing.)

However, if excluded income like Medicaid waiver payments is considered “earned income” (that is, if we don’t require that earned income be “included”) then people with large amounts of excluded earned income do begin to phase out under the “earned income” means testing prong. In other words, it more appropriately reserves the credit only for those who working and are (truly) of limited means, while denying it to those who (truly) are not. I think Congress would approve. I’d also note that the exclusion is necessarily worth more to higher income earners than to lower-income earners -and frequently worthless to EITC recipients, many of whom may not actually have a tax liability at all (thus providing a $0 benefit to the exclusion).

Finally, I’d note (and did in the brief) that Congress has essentially addressed this problem of excluded earned income before -only with non-taxable Combat Pay. A little history is helpful on that point.

For the majority of the EITC’s existence (from 1978 to 2001), earned income actually didn’t have to be “includible” in gross income. Then, in an effort to make the credit easier to compute (not an effort to limit eligibility), Congress added the includible requirement as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. Mostly, Congress made this change because it wanted information returns to give taxpayers (and the IRS) all the information needed for calculating the EITC.

Unfortunately, this meant that active duty soldiers receiving combat pay (which is a mandatory statutory exclusion, and thus not “includible” under IRC § 112) could not treat that pay as qualifying for the EITC. A GAO report noted that this was likely an unintended consequence (see page 2), that accrued the bulk of the benefits to those that made the most money. The Congressional fix was IRC § 32(c)(2)(B)(vi), which allows taxpayers to “elect” to treat excluded combat pay as earned income (it still isn’t taxed). Congress had to make this change to fix an unintended consequence of their own (statutory) making. However, it would be absurd (we argued) to require Congress to fix an unintended consequence wholly created by the IRS through Notice 2014-7.

What Happens Next?

I’ve been in contact with the local VITA providers in my community that see Medicaid Waiver Payments on the front lines -apparently fairly frequently. Their main question is a practical one: what do we tell taxpayers now? The IRS VITA guidance before had been “you can’t get credit for those payments towards the EITC.” In the aftermath of Feigh, can they both exclude and get credit now (as my client did)?

That is an excellent question, which brings up some excellent procedural issues (finally: I promised I’d get to them). The main issue is whether the IRS may now consider Notice 2014-7 completely moribund, such that there is no exclusion period and the Medicaid Waiver Payments must be included. The Court noted that the IRS did not raise the argument that the payments should be includible in income for my client, so it was conceded. But is the IRS stuck with that position now? Can the IRS take a position that is contrary to its own published guidance? What if that guidance is essentially invalidated?

The best case on point for this sort of situation may be Rauenhorst v. Commissioner, 119 T.C. 157 (2002). In that case, the IRS essentially said it wasn’t bound by its own guidance (in that instance in the form of a Revenue Ruling) when the Commissioner took a litigating position directly contrary to it. After receiving something of a slap-down from the Tax Court, the IRS issued Chief Counsel Notice CC-2003-014 (sorry, I couldn’t find any free links), which provided that “Chief Counsel attorneys may not argue contrary to final guidance.” Final guidance includes “IRB notices” (i.e. notices that are published in the Internal Revenue Bulletin), which Notice 2014-7 was.

Further, it does not appear to matter that Feigh essentially invalidated Notice 2014-7. The Chief Counsel Notice specifically includes a section headed “Case law invalidating or disagreeing with the Service’s published guidance does not alter” the rule that Chief Counsel shouldn’t take a contrary position that is unfriendly to taxpayers. In other words, so long as IRS Counsel follows the CC Notice, they should continue to let taxpayers exclude the Medicaid Waiver Payments… And since they’ve already lost on whether those excluded payments are earned income, it is perhaps best of both worlds for taxpayers moving forwards.


Perhaps. But I’m not sure I’d bet the farm on the IRS following the Chief Counsel’s Notice in all cases (and especially for taxpayers working with IRS agents or appeals, rather than Counsel).

But the final procedural point I want to make takes the long-view of things: which is that this never should have happened in the first place, because the IRS never should have overstepped its powers by issuing Notice 2014-7 masquerading as substantive law without, at the very least, following the rigorous notice and comment procedures required of substantive regulations. Had the IRS done so the tax community could well have seen this before the regulation was finalized and it could have been addressed. This may echo from my soapbox, but Notice 2014-7 undoubtedly caused real harm to some of the most vulnerable taxpayers. I know from conversations in the tax community that many low-income earners lost out on a credit they rightfully deserved. I don’t think for a second that was the intention of the IRS when they issued Notice 2014-7. Nor does Judge Goeke in the opinion (see footnote 7).

But, again, tax is a complicated animal: legislating new rules should not be done lightly. Procedure, in other words, matters.

Caleb Smith About Caleb Smith

Caleb Smith is Visiting Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

Comments

  1. Norman Diamond says

    “Congress has essentially addressed this problem of excluded earned income before -only with non-taxable Combat Pay.”

    Congress tried to deal with excluded earned income for the Foreign Earned Income Exclusion. Besides tinkering with whether the exclusion would exist or not and which portion of the earned income would be excluded, there were also some efforts to prevent double dipping. Income excluded by FEIE wasn’t supposed to benefit from Foreign Tax Credit or from Standard Deduction. However, the IRS complained in Tax Court that I obeyed IRS instructions, and backed down when I submitted copies of IRS instructions. Next the DOJ complained in Court of Federal Claims that I obeyed IRS instructions, and I deliberately refrained from arguing the point. You’ll need income about four times the level I had in order to benefit, but it seems to me that double dipping is now mandatory. Triple dipping doesn’t work though. The second part of Form 1116 still wipes out the Standard Deduction (in fact more than 100% of the Standard Deduction gets wiped out when you have both earned and passive income).

    “After receiving something of a slap-down from the Tax Court, the IRS issued Chief Counsel Notice CC-2003-014 (sorry, I couldn’t find any free links)”

    I hope unclefed is only down temporarily, but meanwhile, here’s an archive:
    https://web.archive.org/web/20100206080501/http://unclefed.com/ForTaxProfs/irs-ccdm/2003/cc-2003-014.pdf

    Notice that the DOJ remains free to argue contary to both IRS published guidance and DOJ published guidance.

  2. David Fogel, CPA says

    Sometimes, taxpayers who litigate an issue before a court don’t see the forest for the trees. Before the IRS issued Notice 2014-7, Medicaid Waiver Payments of the type described in the Feigh case were held to be taxable. See Bannon v. Commissioner, 99 T.C. 59 (1992); May v. Commissioner, T.C. Memo. 1993-86; Vogt v. Commissioner, T.C. Sum. Op. 2005-107; Program Manager Tax Advice 2010-7; Alexander v. Commissioner, T.C. Sum. Op. 2011-48; Harper v. Commissioner, T.C. Sum. Op. 2011-56. Now that the Tax Court has ruled in Feigh that despite the exclusion provided by Notice 2014-7, taxpayers may claim EIC and ACTC credits, it’s likely that the IRS will withdraw Notice 2014-7.

    • Norman Diamond says

      After seeing examples in the original posting, it seems reasonable that Medicaid Waiver Payments might be taxable. Poor people will still pay $0 tax on them.

    • Vic Bucher, CPA says

      Sometimes I don’t see the forest for the trees. Thanks Caleb. And thanks, Dave. Nice to see we read the same stuff.

  3. sarah lora says

    Wow! Great work, Caleb & Co.

  4. Erin Stearns says

    Caleb, Congratulations to you and your students on the victory! Well done. Just want to also say thanks for this incredibly well-written and engaging post!

  5. Robert Nassau says

    Very impressive work!
    I worry, however, that for a lot of (most?) taxpayers, including the MWP in earned income for EITC purposes will be a bad thing. For example, we’ve got a client now where one spouse made $25,000 of regular wages and one spouse made $25,000 of MWP. If the MWP is part of earned income for EITC purposes, the EITC goes down dramatically (and is not compensated for by ACTC).

    • Thanks Robert! While I’m not sure how things will work on balance (when I asked our local VITA site, they said confident majority of people they saw were HURT by not being to get the EITC, rather than benefitting from exclusion, but they necessarily see only low income taxpayers), but I do want to make two quick points on that: (1) I’d note that your client would be in quite a different situation if she was a single earner and her only income was that $25K of MWP since she’d get almost no tax benefit from the exclusion, and probably lose out on a couple thousand from EITC/CTC, and (2) somewhat academically, I struggle with the IRS being able to just pick “winners and losers” by just issuing a notice in the first place. Far be it from me to want to steal a tax gift from (mostly middle-class) taxpayers, but in my opinion this is mostly just bringing things back to the correct application of the law (i.e. pre Notice 2014-7). I am, however, keenly aware of how hated I may become by those who did benefit from it. The worst off are definitely those that don’t make a ton of money (like your client), and I don’t relish the negative effects that may result. Perhaps this is something Congress should fix? Dare to dream…

  6. Carl Smith says

    People should stop questioning Caleb for winning this case. Remember that his obligation as a lawyer in the case was to advocate for a victory for his clients — regardless of the adverse effects on some other taxpayers. Congress (or the IRS, if authorized) should deal with the possible policy downsides to some taxpayers.

  7. Kerry Williams says

    Very good . I just received a letter from IRS regarding my 2017 tax return and an unclaimed w2. The unclaimed income was tax exempt Medicaid waiver income and was purposely omitted due to tax exempt status and the lack of clear instructions on how to report such exempt income in a tax return. I trust they will accept my disagreement statement and evidence of 2014-7 qualification. This article is very helpful and relevant to my current IRS communications. Thank you.
    Kerry Williams

  8. Mixed feelings about this. On the 1 hand, It makes sense and benefits this particular taxpayer. On the other hand, there are many of us who were able to exclude IHSS (California DHHS medicaid waiver funds) and have no tax consequence. I am hoping this notice is not able to be rescended because we might end up with a tax liability. What we don’t need is an additional financial burden. Being a parent/care provider is difficult enough.

  9. Fabrice Georis says

    Caled, congratulations! These payments are become somewhat common at VITA sites. While it’s true that, going forward, the inclusion may be detrimental to some taxpayers, it should be neutral or beneficial with respect to prior years. Taxpayers who benefit from the case may file amended returns. Taxpayers who don’t benefit from the case are not obligated to file the amended return, and the odds that the IRS will adjust these returns to conform to the case are virtually nil.

    While it’s li

    • Guillermo A Arce says

      The U.S. Constitution and the courts interpreting the U.S. Constitution favor prospective agency action so that U.S. taxpayers and citizens have notice and certainty regarding the rules governing their financial and personal affairs.

  10. Walter Thies says

    Why would Feigh not also apply to refundable premium tax credits for medical insurance purchased on an Affordable Care Act exchange?

  11. So people not paying into the system get paid refundable credits from the system. It’s kind of like free money on top of free money. That seems more unfair than a dual income household recieving the credit, because the dual income household is at least paying something into the system. In CA these payments to live-in providers are 100% tax free. No payroll taxes. Gross = Net

    At the moment in CA a lot of waiver payment recipients are now pushing for ssi credits on this income. I understand the burden of having to stay home to care for someone, which makes you unable to go out and work to pay into the system for ssi credits later in life. But not paying into it, and then using it…

    This case may have solved that problem, and it will revert back to taxable income. Which will be devastating to middle income households. But on the bright side they will also then be getting ssi credits.

    Would you say I could file taxes for someone, letting them double benefit citing this case and they not get dinged for it?

    • Sorry. I meant ss retirement not ssi. The work credits you get from working. I’m sure you knew that. Anyhow so many people are asking about their waiver payment income right now and I’m a little unsure what the answer is now with this case.

  12. marianne petti says

    Great article. One question. My 2019 W-2 earnings were not included in the Federal which as you know affects my refund for EITC. As a caregiver, this had a huge impact as well for me. As legal guardian and caring for my disabled grandson who lives with me, this is my only income and now loose the credit when filing again in 2019. Has the rule been changed or is this yet another year I can’t the earned income credit?

  13. How does this decision potentially impact other statutory tax benefits provided by Congress? Specifically, if you can choose to allow Medicaid waiver income to qualify for the EITC and CTC, wouldn’t the same apply for IRA contributions?

    I can find no case law for the specific IRA contribution, however, if the Court reasoned that the IRS cannot remove a statutory benefit provided by Congress, is it not reasonable that MWP could also be treated an earned income in determining IRA contributions not dissimilar to doing so for the EITC?

    Any guidance in this regard is much appreciated.

  14. At our VITA sites, we prepare close to 22,000 returns each season. Thank you, Caleb, for bringing the EITC and Additional CTC back for many of our clients who were hurt by Notice 2014-7. Am I correct that this case outcome can be applied to prior years, not just the current tax year? I am trying to determine whether or not to recommend amending returns for clients impacted in tax years 2016-2018.

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